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Supreme Court Set for Argument in ‘High Stakes’ Bankruptcy Case

The U.S. Supreme Court will hear arguments Nov. 6 in a “high stakes” case that may
affect whether financial transactions that underpin corporate buyouts that are mostly
debt financed can be challenged later if the acquisition fails and winds up in bankruptcy
court.

The question that has produced a deep circuit split is whether the “safe harbor” rule,
11 U.S.C. §546(e), prevents a bankruptcy trustee from suing to “claw back” or undo
the pre-bankruptcy sale of stock deemed fraudulent when the transfers were made through
banks even if they acted simply as conduits (
Merit Mgmt. Grp., LP, v. FTI Consulting, Inc.
, U.S., 16-784, Review Granted
5/1/17
).

The court will decide if the section prohibits those kinds of avoidance actions by
trustees even when the financial institutions are not defendants or at risk of any
order for recovery, or when they don’t have a beneficial interest in the transfer.

The Seventh Circuit said that trustees can go after the money in those cases. Some
bankruptcy law scholars predict high-court reversal of that decision based on a “misguided”
plain language reading of the statute. But they warn that such a ruling would be contrary
to the purpose of the section in play here and the overall Bankruptcy Code.

Important Question

“The case is very important for bankruptcy practitioners, as it raises the larger
question of whether securities buyouts can ever be avoided,” Charles J. Tabb, of counsel,
Foley & Lardner LLP and Mildred Van Voorhis Jones Chair in Law at the University of
Illinois, Champaign, Ill., told Bloomberg Law in an Oct. 22 email.

The National Association of Bankruptcy Trustees emphasized in an amicus brief the
significance of the ruling for creditors.

“A trustee’s ability to recover a constructively fraudulent transfer is often the
creditors’ only hope for a meaningful recovery, and the Court’s decision will have
a dramatic effect on the ability of amicus’ members to achieve that central objective
of the Bankruptcy Code,” the association wrote in its brief.

The issue is prominent in leveraged buyout cases, where the purchase of a company
is basically financed by the assets of the purchased company.

Reversal by the justices “would prevent a trustee from attempting to unwind a failed
leveraged buyout, even when it is a purely private transaction, as most are,” the
trustees association said.

“Encumbering a company’s assets to finance its own acquisition poses a unique hazard
to unsecured creditors,” it said.

“The stakes are high,” Prashant M. Rai told Bloomberg Law in an Oct. 20 email. Rai
is a restructuring attorney at Weil, Gotshal & Manges LLP, New York. He’s written
a
Bloomberg Law Insights article on the issue.

“The Supreme Court needs to resolve the split of authority to discourage forum-shopping,”
he said.

“An affirmance of the Seventh Circuit by the Supreme Court certainly will cause a
stir with the New York and Delaware bankruptcy bars,” where most large commercial
cases are heard, he said.

The Transfer in Question

The case stems from a dispute between two companies hoping to create a “racino"—a
race track and casino—in Pennsylvania.

Valley View Downs L.P. and Bedford Downs Management Corporation both sought the last
state license available for harness racing. They each opposed the granting of the
license to the other.

Valley View Downs eventually agreed to buy Bedford Downs stock so it could pursue
the license unopposed. Merit Management Group L.P., the petitioner in this case, owned
about 30 percent of Bedford Downs.

In a transaction that originated with Credit Suisse, as a lender to Valley View, about
$16.5 million passed through an escrow held by Citizens Bank of Pennsylvania to Merit
Management for its shares in Bedford Downs.

Valley View got the harness racing license, but it couldn’t secure a gaming license
for the casino and wound up filing Chapter 11.

A reorganization plan was confirmed, and FTI Consulting Inc. became trustee of a litigation
trust. That trust sued Merit Management to recover the $16.5 million it received as
a constructive fraudulent conveyance.

The legal theory was that Merit didn’t give reasonably equivalent value for the payment,
and that the transfer occurred when Valley View was insolvent, or it was rendered
insolvent by the transfer.

The Safe Harbor

Merit Management answered that Section 546(e) of the Bankruptcy Code was a defense
to the action. That section provides that a settlement payment made “by or to (or
for the benefit of)" certain protected financial institutions can’t be sued for constructive
fraudulent conveyances (as opposed to cases of intentional fraud).

Even though the parties to the transfer were Valley View as the purchaser of the Bedford
Downs stock and Merit Management as the seller, Merit Management argued that because
both Citizens and Credit Suisse are protected financial institutions, the Section
546(e) safe harbor applies to bar the action.

The Seventh Circuit disagreed and held that where the financial institutions are mere
conduits of the transaction, the safe harbor would not bar the action against the
defendant.

That decision put the circuit at odds with other circuits considering the question,
including the Second, Third, Sixth, Eighth and Tenth Circuits. The Eleventh Circuit
agreed with the Seventh.

“The Second and Third Circuits house many of the largest corporate bankruptcies. Therefore,
if the Supreme Court adopts the minority view of the statute, many noteworthy transactions
will come under scrutiny that previously would have fallen within the safe harbor,”
Rai said.

A Plain Language Analysis

“I think that the Supreme Court will reverse the Seventh Circuit, based on a misguided
plain language reading of Section 546(e),” Tabb said.

“The problem is, this reading makes absolutely no sense whatsoever,” he said. “The
qualifying financial entities for whom the safe harbor is written are dissociated
entirely from the transfer sought to be avoided. None of those financial entities
is a target of the avoidance or subject to any risk of recovery,” he said.

“To give a private non-financial party (like Merit), who is not in any way an intended
beneficiary of the safe harbor, immunity under that safe harbor because of the happenstance
that a qualifying entity was somewhere in the chain of transfers, is absurd,” Tabb
said.

But apparently such an absurd result is likely, as experts expect the Supreme Court
to favor a plain reading of the language.

The court should reverse the Seventh Circuit because the language is clear and unambiguous,
Samir Parikh told Bloomberg Law Oct. 24. Parikh is a professor of law at Lewis & Clark
Law School, Portland Ore. There’s nothing in the statute that suggests that the financial
institution has to have a beneficial interest in the transfer, he said.

Unfortunately, the clear language doesn’t comport with what the legislative history
suggests the law was designed to do, Parikh said. Parikh is an editor of
Bloomberg Law: Bankruptcy Treatise.

Purpose of the Safe Harbor

Congress enacted the section to protect the nation’s financial markets from the instability
caused by the reversal of settled securities transactions. It was intended to minimize
the displacement caused in commodities and securities markets in the event of a major
bankruptcy affecting the industries and to prevent the ripple effects created by the
insolvency of a commodities or securities firm from spreading to others and possibly
threatening the collapse of the affected industry, according to
Bloomberg Law: Bankruptcy Treatise, pt. II, ch. 74 (D. Michael Lynn et al. eds., 2017).

And significantly, there’s nothing to suggest that the law was intended to protect
shareholders enriched by failed leveraged buyouts.

“LBO’s should be subject to fraudulent transfer law, but I don’t think the court can
get there,” Parikh said. “The language of the statute is too clear; there are no grounds
to look at the legislative history,” he said.

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